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On Our Radar

Report: Goldman's Inside Track on U.S. Oil-by-Rail Boom

While the role of Goldman Sachs Group Inc (GS) in global metals markets has fallen under a harsh regulatory spotlight this summer, the bank has also quietly enjoyed a privileged front-row seat to one of the most dynamic trading trends to emerge from the U.S. shale oil boom: shipping crude by rail.

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Through a previously unreported minority investment in a small, privately held Texas-based firm called U.S. Development Group (USD) in 2007, Goldman Sachs has played a leading role in financing the expansion of nearly a dozen specialized terminals that can quickly load and unload massive, mile-long trains carrying crude oil and ethanol across the United States.

Dan Borgen, president and chief executive of USD, said the firm he helped found two decades ago has benefited from a regular exchange of ideas with Goldman, as well as from its financial clout.

"It's great for someone who tends to be creative and entrepreneurial to bounce ideas off smart folks who understand the strategic nature of the business," Borgen said in an interview. "We lean on them for advice and they are some smart people. It's one of the reasons we accepted their investment years ago."

To be sure, there are important distinctions between Goldman's involvement with USD and with Metro International Trade Services, the warehousing group that is now the subject of a U.S. regulatory inquiry and lawsuits alleging it used anticompetitive practices that helped drive up the cost of aluminum. Goldman has denied the allegations.

Unlike Metro, a wholly-owned subsidiary of Goldman's J. Aron trading operation, USD was a minority-stake investment by a different part of the bank, a Goldman spokesman said in response to queries. There is no indication that Goldman played any role in USD's operations or ever benefited beyond its financial stake in USD. Both are balance sheet investments made with the bank's own capital rather than investor funds.

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Still, the USD stake, which has fallen from 49 percent in 2007 to less than half that now, shows that Goldman's interests in the commodity industry run deeper than widely known, and extend beyond the Metro warehouses and its ownership of a Colombian coal mine, its two most public holdings.

In principle, its ownership stake in privately held USD could provide the bank with valuable insight as the shipping crude by rail moved from a niche play to a mainstay of the U.S. market, as booming U.S. oil production outstripped pipeline capacity in many regions.

HOW PHYSICAL TO GET

While private sector investments have long been a common part of merchant banking, the stakes may attract additional scrutiny at a time of unprecedented public and political pressure on Wall Street investments in commodities markets, particularly ownership of infrastructure such as metals warehouses and trading of physical commodities.

Lawmakers have questioned whether commercial banks, guaranteed by the Federal Reserve, should own oil tankers or run power plants - activities that may expose them to massive financial risk in the event of a spill or meltdown.

While the bank isn't obliged to reveal every investment it makes with its own money, lawmakers on the Senate Banking Committee have complained it is almost impossible to know how deeply involved banks are in the industry, due to the lack of disclosure.

The Federal Reserve must make a decision by September that will determine whether former investment banks like Goldman will be allowed to continue owning and operating physical commodity assets. More broadly, it is also reviewing a landmark 2003 decision that first allowed commercial banks to trade physical commodities.

Some banks, including JPMorgan Chase & Co (JPM), are opting to withdraw from physical trading, because of the regulatory pressure and several years of diminished margins.

The Goldman unit with an interest in USD, GSFS Investments I Corp, has also cut its holding in USD, although the reduction pre-dates the current debate over how deeply Fed-backed banks should be allowed into commerce. As a "merchant" investment held at arm's length from the bank, the stake must divested by Goldman by 2017, according to Federal Reserve rules.

GSFS cut its roughly 49 percent shareholding to about 33 percent in 2011, according to Texas Franchise Tax Public Information reports. Its share has fallen further since then, according to a person familiar with the matter.

Neither Goldman nor USD's Borgen would comment on the exact size of the current stake, nor why the bank was reducing it. USD is an employee-owned business, Borgen said. He declined to talk about the ownership structure in more detail.

BENEFITS?

U.S. Development Group has been in business for two decades, but it has only gained a high profile recently as it shifted from building up ethanol-related rail terminals to tapping into the shale crude oil boom.

Borgen said the initial deal with Goldman came about after USD had turned down other would-be investors. The company had already made its mark in the industry with a series of projects including small-scale rail projects, large-scale "storage in transit" for the petrochemicals industry and some wholesale oil-by-rail diesel fuel arbitrage.

"Because we're not public we're able to get out there early and put our stake in the ground before others identify the market opportunities that are there," said Borgen. "We start things and hopefully they become industry solutions."

At the time of Goldman's investment in 2007, well before the surge in North Dakota crude production had begun, USD was in the midst of building ethanol terminals across the United States, including one in the New York Harbor trading hub, where prices for benchmark U.S. gasoline and heating oil are set. It sold three of those terminals to Kinder Morgan <KMP.N> in 2010.

It later shifted to crude oil facilities, building up five such oil-by-rail terminals - which it sold to Plains All American Pipeline (PAA) for $500 million in late 2012, leaving the company cash-rich and asset light.

Understanding the trading flows through such lynchpin oil facilities can provide valuable insight for oil traders, who scour the market for information that may help them predict how much oil is being shipped to different parts of the country.

Large price discounts for oil in locations poorly served by pipelines have offered traders attractive opportunities if they can figure out how to get the crude to higher-priced markets. Data on crude-by-rail shipments is particularly opaque, with government figures only available months after.

It is not clear what - if any - information about the USD investment found its way to Goldman's J. Aron arm. A person familiar with the business said J. Aron traders had never chartered oil through the USD terminals, nor did they have direct access to information from the company. Borgen declined to comment on USD's customers.

Borgen said he did not know if Goldman had benefited from the conversations with USD in the same way that USD had learned from Goldman's bankers: "You'd have to ask them," he said.